Bikes, Businesses and Gearing

Whilst probably baffling some of you with numbers, this post does explain why my twitter name is @kevverage.

I took my single-speed bike out for a spin last night (a bike with no gears for those non-cyclists among you) and as I laboured up one of the steeper climbs I got to thinking about gearing. Well, I actually got to thinking about why I would be so dumb as to choose to ride a bike with no gears; but once I was able to think about something other than breathing my thoughts turned to business.

Now gearing (or leverage) in business is a wonderful concept and perfectly analogous with the gearing most people are familiar with on a bike. There are broadly speaking two types of gearing that are normally referred to in business: Financial and Operational. I will focus here on Financial gearing and save Operational gearing for another day.

Financial gearing basically refers to the relative amount of debt on a business i.e. the level of debt versus the level of equity (or money put in by the shareholders).

A High level of debt, like a high gear on a bike, allows you to travel faster (it can also provide 'leveraged' shareholder returns, but we will come back to that). The debt gives you the cash to fund expansion, invest in working capital, expand store portfolios, make capital investments etc. When you have a following wind and a downhill slope ahead of you, having high levels of debt are great and you can fly along. Of course - like being in the big ring on a bike - when you hit a headwind or an uphill slope you will want to change gear; this is a lot easier on a bike than with a business (maybe analogous to the pre-derailleur days when riders would have to remove their back wheel and replace it the other way round to get 'the other' gear). The interest payments required to service this debt (the debt that helps you steam along when the going is easy) can bring down the business when you hit hard times. If the profit levels drop below those required to pay the interest - like struggling to turn the pedals when stuck in too high a gear - the business may grind to a halt and you face that horrible moment when you have to 'step off'.

I mentioned 'leveraged' shareholder returns; these are the main reason why businesses (and Private Equity investors) are so keen on debt and high gearing.  The simplest illustration involves buying a business (although the numbers work equally well for existing investors reinvesting in a business) so let me illustrate with a company being bought for £10m, generating £9m of cash over 5 years and then being sold for £15m (this is of course a highly attractive scenario however you finance it);

1. The company is bought using £1m of equity (money from investors for the shares in the business) and £9m of debt.  The debt is repaid using the cash generated over 5 years.  Allow me to finesse interest payments here for simplicity and say that over the 5 years the interest payments are £2m and paid directly by the investors. So when sold the investors get £15m return for their £1m+£2m = £3m investment or a £15m/£3m = 5x return
   
2. The company is bought using £10m of equity and no debt.  The shareholders therefore receive all of the £9m generated + the £15m proceeds of the sale = £24m return for their £10m investment or a £24m/£10m = 2.4x return

Now there are subtleties around interest payments, the timing of cash-flows and the discounted present value of cash that mean scenario 2. is actually slightly better than this illustration (the £8m generated by the business is received sooner than the £15m) ... but hopefully you can see by the magnitude of the numbers that scenario 1. at 5x is far more attractive than scenario 2. at 2.4x  Of course scenario 2. generates a greater absolute amount of return for the investors so you would only choose scenario 1. if you had something else to do with the spare £9m -- I think we can assume we would.


Back to our bike gearing analogy -- what happens in scenario 1 is that the 'gearing' allows a small amount of equity (a small degree of pedal turn) to buy a big business (to make a greater number of wheel revolutions).  Great as long as you don't hit tough times where - as described above - servicing the debt (turning the big ring) can bring you to a halt and make your return zero.

As an aside here, if you are a Private Equity player with a portfolio of businesses you can afford to risk a few grinding to a halt because of too much gearing given the exceptional returns you make when high gearing works. As an entrepreneur with your eggs in one basket, your view of the appropriate risk/return trade-off is likely to be somewhat more conservative. This quite rational but fundamental difference between PE investors and Entrepreneurs has created an awful lot of wealth for PE professionals and a fair amount of frustration for entrepreneurs over the last 15 years or so -- particularly when banks were so keen to provide debt to PE companies but loath to offer similar support to independent business.  But my rant on banks will need to wait until another post.

So why does this explain @kevverage?

The terms 'gearing' and 'leverage' are often used interchangeably. The debt is the 'handle', the equity the 'bit under the business' (the fulcrum just sits where debt changes to equity along the lever, which is why I don't like this analogy as much as the gearing one).  In my early consulting days leverage was talked about *a lot* and resulted in such phrases as 'leverage some beverage'  or - slightly more bizarrely - 'could you leverage me the salt?'.  It is but a small step from there to Kevverage ...